MARKET REVIEW
First Quarter 2012

he global fixed income markets are still fixated on central bank policy and the European debt crisis. Investors are almost certain to be frustrated no matter what policies are announced, because the issues will take time to play out.

Returns across the various income sectors demonstrated mounting concern about inflation as well as the state of the markets once the Fed steps away. The Treasury yield curve steepened. At yields below 3% for all but the longest maturity bonds, the probability of a real rate of return is close to zero. The Federal Reserve still has “Operation Twist” in effect, which has kept the curve artificially flat. When it ends, the curve is expected to steepen. However, the possibility of the policy’s renewal, or some variation of it, is likely keeping long term rates below their proper level.

The search for yield has shifted from longer term bonds to segments of the market like high yield. On average, high yield bonds gained 5%, and the lower the credit quality, the higher the return. Emerging market debt also soared, gaining 6.5%. Although yields remain much higher there, we do not believe emerging market debt represents the best opportunity at this time. Most emerging market countries are seeking to weaken their currency, either through restrictions on trading, lower interest rates or both. The yield premium is substantial over government bonds in the developed world. But corporate debt and mortgage debt offer similar yields without the currency risk.

Senior loans gained 3.8%. We believe senior loans represent an excellent risk/return tradeoff in the current market environment. They provide both high income and protection should the Federal Reserve reverse course and raise short term interest rates. Mortgage and real estate related securities were all positive, but there was a wide disparity in performance. Government backed mortgages earned about 1%, while private bonds and REITs gained 10%. The Treasury Department recently completed its $225 billion sale of mortgages it purchased from Fannie Mae and Freddie Mac during the financial crisis. The Federal Reserve still holds $835 billion in mortgages on its balance sheet.

Discounts on closed-end funds narrowed somewhat during the quarter, but the majority of the Portfolio’s return came from income and unrealized capital gains. The allocation to senior loans was increased to 40%. The Portfolio has a high level of diversification within the sector through a number of funds, as well as through an ETF, which does not run the risk of having its shares decline due to a widening discount. Holdings in funds engaged in equity based income strategies, primarily covered call writing, have been reduced.

Portfolio duration is now below two years (excluding equity strategies that do not have duration). Our positioning reflects the view that the global economic recovery will continue, though at an uneven pace, and with the strong possibility of further central bank action. There is a limit to the Fed’s ability to suppress rates, even as it is hard to quantify what the limit is. The 7.2% yield on the Portfolio implies that the types of securities it holds may be attractive to investors as they leave the perceived safety of Treasuries.